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Compensation Payments

Table of Contents

Commentary

Compensation for lost profits or income receipts

The surrogatum principle provides that the character of a receipt of an award of damages or of an amount received in settlement of a claim as a capital or income receipt depends on what the amount was intended to replace, so that if the replaced amount would have been taxable in the recipient's hands, the award or settlement amount will also be taxable (Tsiaprailis). In an English case (London & Thames Haven v. Attwooll) which has been frequently cited in Canada, the principle was expressed as follows:

Where, pursuant to a legal right, a trader receives from another person compensation for the trader's failure to receive a sum of money which, if it had been received, would have been credited to the amount of profits (if any) arising in any year from the trade carried on by him at the time when the compensation is so received, the compensation is to be treated for income tax purposes in the same way as that sum of money would have been treated if it had been received instead of the compensation. The rule is applicable whatever the source of the legal right of the trader to recover the compensation.

Relatively straightforward applications of the surrogatum principle include the taxability of: business interruption insurance proceeds (Seaforth, Westar Mining and Cominco); damages (or settlement amounts) for unpaid professional fees (Societe d'Ingenierie), a finder's fee (Manley), a loss of profits from a parking lot due to expropriation (City Parking) or a quantum meruit claim (Cox); compensation received by a landlord for the termination of a lease, viewed as compensation for lost rents (Spezzano, Monart, Grader, Reusse Construction) or foregone reimbursement by the tenant of landlord expenses (Farb Investment); advances against annual production subsidies (Smart v. Lincolnshire); and damages received for the failure of a supplier to supply goods for resale by the taxpayer (Brussels Steel) or land inventory (Zygocki).

It has been suggested that the surrogatum principle does not apply to amounts received pursuant to a fraud (namely, a ponzi scheme) rather than a legal right (Johnson). However, an arguably gratuitous payment received as compensation for past work or loss of future profits has been found to be taxable (Rolfe v. Nagel).

Compensation for increased expenses (or capital expenditures)

The surrogatum principle also indicates that if an award compensates the taxpayer for additional expenses incurred by it on income account, the award also will be received on income account (Goff). Thus, compensation received by a taxpayer for increased rent expenses to be incurred by it as a result of an agent's negligence have been found to be an income receipt (Donald Fisher), as have government wage subsidies received by a manufacturer (Poulter v. Gayjon).

Conversely, if the taxpayer receives compensation for additional expenditures which it incurred on capital account (which might be the case where the compensation only reimburses it for its costs without a profit element), the compensation likely will also be received on capital account (Consumers' Gas, Pacific Northern -respecting pipeline relocations at customers' request). However, such compensation payments may be deemed to be includible in income under s. 12(1)(x) unless an election is made under s. 13(7.4), 53(2)(s) or 12(2.2).

Insurances proceeds received by a company on the death of a key employee have been found in the UK to be taxable on the basis that they were received for the loss of an employee who was expected to generate taxable receipts (Keir & Cawder).

The Consumers' Gas principle referred to in the paragraph above likely will not apply where it is a normal incident of the taxpayer's business to receive payments inducing it to acquire a capital asset, e.g., cash payment received in order to induce it to enter into leases where there are no restrictions on how it may apply those receipts (Ikea, IBM Canada, Nesbitt Thomson, see also Yesac) - and, conversely, a one-off payment received as an inducement to enter into a lease may be a capital receipt (Trans Canada, 87 C.R. - Q.14) before considering the application of s. 12(1)(x).

Compensation for material damage to a business as a whole

Although, as noted, compensation for damages to a business causing a loss of profits generally will be a taxable receipt, damages or other compensation for the loss or material crippling of a business of the taxpayer generally will be a capital receipt (Pe Ben), as is such a receipt for material damage to the taxpayer's business (H.A. Roberts, BP Canada), including where the amount is calculated by reference to future sales which were lost (Import Motors) - or for the loss of a material line of business (Parsons & Steiner). However, compensation for acts which do not have a materially adverse effect on the taxpayer's business as a whole will be income receipts (Charles Bell, St-Romuald, CNR - see also Packer Floor, Deeny & Ors.), even perhaps where there is a permanent impairment to the taxpayer's business (see Prince Rupert).

CRA has accepted that negotiated damages received by two advisors to a REIT for termination of their management advisory contracts with the REIT gave rise to proceeds of disposition of capital properties (the contracts) given that these contracts were their principal source of revenue (2002-014796).

Compensation for damage to or loss of other capital assets

In the English case referred to above (London & Thames Haven v. Attwooll), it was found that even though the compensation for lost profits was occasioned by damage to a capital asset (and compensation for the costs of repairing that asset were received on capital account), the compensation for lost profits was taxable. Similarly, lost profits for failure of a Canadian processing facility to perform to standard were taxable (Mohawk Oil).

Damages received for infringement of a trademark or patent are taxable if they are computed by reference to the diminution in profits resulting from the infringement (Donald Hart), or if the claim was for lost profits - even if the amount ultimately received bears no calculated relationship to the lost profits of the taxpayer (Bourgault). Conversely, damages received for copyright infringement were capital receipts where there was no evidence of lost sales (Cartwright).

The Goff case held that if the expense for which the award is compensation is a capital expenditure under general principles but is deemed by a specific provision to be a deductible expense, the award will be received on income account rather than capital account.

In Eaton Co., a lump sum received by an anchor tenant for surrender by it of its right to participate under the lease in a share of the profits of the landlord from the relevant shopping centre, was characterized as compensation paid for the diminution in value of a capital asset (its leasehold interest).

Compensation for the loss of a capital asset (e.g., a power plant - Alberta Power; or the cancellation of a non-compete covenant - RCI) is a capital receipt. In Young, two lump sum payments received by the taxpayer for the termination of a contract under which he was entitled to receive $40,000 per annum for life were found to be capital receipts (namely, proceeds of disposition of the contract) notwithstanding that the annual payments (received in compensation for the termination of a sales agency arrangement) likely were income to him.

Personal injury awards and other exempt receipts

Personal injury awards have been found to be non-taxable even though they were computed having regard to income lost as a result of the injury (Cirella).

Damages received by an individual in an action to preserve the individual's reputation have been found to be exempt receipts (Coughlan).

Cases

The taxpayer realized gains of $1.3 million from periodically placing funds with a rogue ("Lech") who, it was later discovered, had not invested the funds in options trading but instead used them in a ponzi scheme. After finding that these gains were not income from a source, Woods J. went on to find (at TCC para. 44) that the distributions to the taxpayer also should not be considered under the surrogatum principle to have been received in lieu of income pursuant to a legal right because the amounts instead had been received pursuant to a fraud.

Although the Court of Appeal reversed the trial decision, Sharlow J.A. did not comment on the findings at trial relating to the surrogatum principle. The Court of Appeal's reasoning was based principally on a finding that the funds were income from a source, as the taxpayer had contracted to receive and in fact did receive a return on investment.

compensation, re capital expenditure that was deemed on income account, was income receipt

The taxpayer incurred expenses in obtaining a reversal of most of the costs that the Ontario Municipal Board had awarded against it. These expenses were capital expenditures but were deductible and deducted by it under s. 20(1)(cc). The taxpayer then received a settlement amount from the law firm that had acted for the OMB in respect of its negligence in having caused the OMB to impose the costs against the taxpayer. This $400,000 receipt was income to the taxpayer on the basis of the principle that the tax treatment of the receipt was to be determined by reference to the tax treatment of the expenditures that had been made, which had been deducted in computing its income.

compensation received by landlord for lease cancellation was on income account

There was no reviewable error in the finding of C. Miller J below that a lump sum payment received by the taxpayer from the sole tenant of its building in consideration for the termination of the lease was received on income account. Noël JA stated (at paras. 28-9) that he saw no error in the findings below that "the sole capital asset acquired by the appellants was the building and that the long term lease was but a means of exploiting that asset," and that "the payment in issue was intended to replace rents otherwise payable under the long term lease."

T. Eaton Co. Ltd. v. The Queen, 99 DTC 5178 (FCA)

buyout of participation clause in lease (without cancellation of lease) gave rise to capital gain

The taxpayer, a Canadian retail merchant, entered into a long-term lease of retail space in a shopping centre in 1955. The lease included a "participation clause" which entitled it to 20% of the shopping centre's annual net profit over the duration of the lease term and any renewal period.

In finding that lump sum received by the taxpayer as a result of a negotiated buy-out by the landlord of the participation clause was a capital gain, Robertson J.A. stated (at p. 5185):

"Compensation paid for the diminution in value of a leasehold estate is on capital account. The cancellation of the participation clause had as much effect on the value of the leasehold interest as would a fire, which partially destroys the premises. Since compensation for such a loss would be on capital account, the same should hold true for a voluntary loss arising from the cancellation of a contractual right which forms an integral component of a capital asset."

tenant inducement payment was received in course of retail store operations

A tenant inducement payment which the taxpayer (a furniture retailer) became entitled to receive as a result of entering into a lease of premises, was not a tax-free capital receipt. The payment was not received as a reimbursement for the cost of capital property (the payment was made free of any conditions for or stipulations as to its use). The taxpayer's obligations under the lease essentially consisted of the payment of rent and the operation of its business in the leased premises. These were clearly expenses incurred in the day-to-day operations of the business and were therefore on revenue account. Whether the tenant inducement payment represented a reduction in rent or consideration for the taxpayer's assumptions of these revenue account obligations, it should be included in its income.

Damages which the taxpayer received as a general partner in two limited partnerships from a law firm for negligence in drafting the partnership agreements gave rise to income receipts given that the damages were quantified by reference to the present value of the management fee income that was lost as a result of the improperly drawn agreements and given that the taxpayer continued to provide management services to the partnerships under the improperly drawn agreements. In light of the second point, it was found that "the solicitors' errors did not destroy, sterilize or materially cripple the whole of the profit-making structure of the business operations of the general partners ... Such general partnership interest is simply impaired, albeit permanently." (p. 5247).

The Queen v. Mohawk Oil Co. Ltd., 92 DTC 6135 (FCA)

damages received both for breach re depreciable property and lost profits

A lump sum of U.S. $6 million which the taxpayer received from a U.S. supplier in settlement of a claim for loss of profits and unrecovered costs resulting from the failure of a waste oil reprocessing plant to perform as promised did not constitute a non-taxable windfall, and instead constituted a taxable receipt and proceeds of disposition of depreciable property, in the proportions assessed by the Minister.

The dealer network of the taxpayer distributed the outboard motor products of Outboard Marine Corporation of Canada Limited ("OMC"), along with products of other companies such as Volvo Penta marine engines and snowmobiles of Bombardier. $300,000 in damages which the taxpayer received from OMC for the cancellation of its right to distribute the products of OMC was found to be an income receipt in light of the relatively small adverse impact of the cancellation upon its business. The taxpayer's operations were "fashioned in such a way so as to be able to absorb the shock of a termination of one of the several parts of its business as one of the normal incidents to be anticipated" (p. 6521).

A payment of $1.3 million which the taxpayer received from Imperial Oil as compensation for the termination of a contract for the sale of waste oil to Imperial Oil after the collection by the taxpayer of such oil from Imperial service station operators, was held to have been received by the taxpayer on income account in light of the facts that the cancellation of the contract (which, in any event, was terminable on 24 months notice) did not have a significant adverse effect on the taxpayer's business, and the compensation was calculated by reference to lost income from the contract.

Westar Mining Ltd. v. The Queen, 88 DTC 6505, [1988] 2 CTC 349 (FCTD)

Proceeds of a business interruption insurance policy clearly were income.

$227,000 which the taxpayer, a construction contractor, received on the termination of its contract was held to be an income receipt in light of: (1) the smallness of the payment in relation to the annual revenues of $10MM to $20MM of its business (a civil engineering division, which did not go out of business as a consequence of the cancellation); (2) the termination appeared to have been attributable to performance delays by the taxpayer and apparently was not wrongful; and (3) the payment was calculated only to cover the loss which the taxpayer had suffered, to the date of termination, on the contract.

C.N.R. v. MNR, 88 DTC 6340, [1988] 2 CTC 111 (FCTD)

The termination of a major contract for the intermodal shipping of 250,000 tons of goods and materials over a five year term from Edmonton to the Syncrude project at Mildred lake did not result in a serious dislocation to the taxpayer's shipping business or cause any of its major assets to become redundant, and amounts purportedly paid to the taxpayer as liquidated damages were business income rather than capital gains or eligible capital amounts.

The termination by Northern Alberta Railway of its subcontract with the taxpayer for the trucking of equipment and materials from a railway yard in Fort McMurray to the Syncrude plant at Mildred Lake put an end to the taxpayer's intermodal operations (although it did not affect the other businesses of the taxpayer including a general oil field transportation business), and compensation paid by Northern Alberta Railway to the taxpayer accordingly was received by it on capital account.

The taxpayer, which derived most of its revenue from a natural gas distribution business, was frequently obliged to relocate segments of its pipelines at the instance of various persons or authorities, and negotiated reimbursing payments from them for all or part of its relocation costs. The taxpayer was not in the business of relocating its pipelines, there was no profit for the taxpayer in these reimbursements because they never exceeded its costs of relocation, and the reimbursement payments accordingly constituted capital receipts.

In the Federal Court of Appeal, it was found that accounting principles for depreciable assets had no particular relevance.

The taxpayer received $429,000, net of legal costs, in settlement of its action against a supplier of graded reinforcing steel rods for breach of its agreement to deliver 17,000 tons of such rods. Since the quantum of the taxpayer's claim was based on the profits it would have made on reselling the rods in the ordinary course of its business of trading in steel products, and since the non-delivery by the supplier did not materially impair or cripple the taxpayer's business, the receipt was a taxable profit.

An amount of $560,650 paid to a professional engineering firm in settlement of its action against a client for unpaid professional fees was an income receipt.

The Queen v. Manley, 85 DTC 5150, [1985] 1 CTC 186 (FCA)

When an individual ("Levy") failed to honour his agreement, purportedly made on behalf of shareholders of Levy Industries Ltd., to pay the taxpayer a 2% finder's fee if the taxpayer found a purchaser for their shares, the taxpayer received damages from Levy for breach of warranty of authority. If the taxpayer had received the 2% finder's fee, it would have been profit from an adventure in the nature of trade. The damages received from Levy accordingly were to be treated the same way for income tax purposes.

Zygocki v. The Queen, 84 DTC 6283, [1984] CTC 280 (FCTD)

The taxpayer received $190,712 in return for waiving her rights under a judgment granting her (along with others) the right to require a company ("Hillwood") to specifically perform an agreement whereunder Hillwood had agreed to purchase a property owned by the taxpayer and the others. Since the taxpayer was in substance being compensated in respect of an interest in land which, if she had disposed of it directly, would have been taxed on income account, the settlement proceeds of $190,712 were fully taxable.

Payments received from both government and private sources to compensate for the cost of relocating pipelines were capital receipts because the relocations did not affect the taxpayer's profits from operations.

Cox v. The Queen, 82 DTC 6287, [1982] CTC 322 (FCTD)

The executors of an estate, who were sued by the taxpayer in an action whose main chance of success rested on a quantum meruit claim of the taxpayer for services that he had performed for the deceased, settled the action by conveying land to him and his nominee. Only that portion of the apparent value (as demonstrated by a subsequent sale) of the land that represented the amount of his quantum meruit claim was added to his income, the balance being a tax-free receipt.

An amount received by the taxpayer in settlement of an action against one of its carpet suppliers for wrongful termination of their distributorship agreement could not be characterized as compensation for the loss or crippling of the taxpayer's profit-making apparatus, and thus was not received on capital account. In fact, sales and gross profits continued at about the same level after termination. The amount instead was compensation in lieu of notice and was therefore a revenue receipt.

Insurance proceeds from business interruption coverage received by the taxpayer following the destruction of its premises by fire were revenue receipts.

Cirella v. The Queen, 77 DTC 5442, [1978] CTC 1 (FCTD)

Special damages awarded to an employee for loss of income over the period of time prior to judgment resulting from the impairment of his earnings capacity by personal injury, were non-taxable. These damages "were in no sense earned or gained in the pursuit of any calling or trade or from property but arose from the injury done him."

MNR v. Import Motors Ltd., 73 DTC 5530, [1973] CTC 719 (FCTD)

periodic payments styled by payor as compensation for lost discounts were damages for crippling of business

A Volkswagen dealer, which also was the exclusive distributor of Volkswagen products in Newfoundland, was found to have received twelve monthly payments from Volkswagen totalling $100,800 as compensation for the loss of its distributorship business as a result of the decision of Volkswagen to perform the Canadian wholesaling function itself, notwithstanding that Volkswagen purportedly paid these amounts as compensation (in the form of discounts) for the additional margins that the dealer would have enjoyed for one year as a distributor. It was noted that "the loss of the distributor franchise seriously crippled the whole of the Respondent's profit-making structure." The payments accordingly were capital gains.

compensation for termination of (relatively significant) mortgage agency operation was capital receipt even if not a separate business

The taxpayer, which carried on various real estate related businesses, was found to conduct an operation of collecting mortgage payments as agent for several mortgagees as a separate business. An amount which it received, pursuant to a major agency contract, for the cancellation of that contract was found to be a capital receipt given that the effect of the cancellation of that contract was to terminate its mortgage agency business. Furthermore, even if the mortgage agency operation was not a separate business, it nonetheless was important to the taxpayer (representing up to 51% of its net income) which again pointed to the compensation payment being a capital receipt.

Monart Corp. v. MNR, 67 DTC 5181, [1967] CTC 263 (Ex Ct)

compensation for relinquishing remaining rents

One of the tenants of the taxpayer's office building advised the taxpayer that the tenant's obligations under its lease would be assumed by the owner ("Dorchester") of another office building which was under construction. Dorchester paid the taxpayer the lump sum of $75,000 in consideration for the taxpayer giving up its rights under the lease including the right to receive the remaining six annual rentals of $110,041 per year. Dumoulin J. held that the sum of $75,000 (which was calculated on the basis of a rental loss of some six to nine months before a new tenant was found) was received by the taxpayer as a normal incident of its rental activities, and was fully taxable.

Parsons & Steiner v. MNR, 62 DTC 1148 (Ex Ct)

capital receipt for cancelation of distributorship

Compensation received by the taxpayer, which carried on the business of a manufacturer's agent and wholesale merchant in china and related wares, for the cancellation, after 18 years, of its agency arrangement for the distribution on commission of Doulton china in Canada, was a capital receipt.

Grader v. MNR, 62 DTC 1070, [1962] CTC 128 (Ex Ct)

Halfway through a five-year lease of a movie theatre from the taxpayer, the tenant agreed to pay the taxpayer a "rental" of $600 per month for the balance of the term of the lease in consideration of being allowed to cease operating the theatre. The taxpayer was entitled pursuant to this lease-cancellation agreement to thereafter occupy the premises or rent them out for the balance of the term of the lease. Kearney J. held that the monthly payments received by the taxpayer pursuant to the lease-cancellation agreement:

"should be regarded in his hands as rental received, or payments in lieu of rental, or in the nature of casual profit derived from a property" (p. 1074)

payment received on buyout of JV interest found to be compensation in lieu of future profits

Shortly before the completion of a joint venture relating to the construction of a portion of a pipeline, the taxpayer, rather than agreeing to receive an interest in the machinery and equipment which was used in the joint venture, agreed to receive a return of its capital contributions to the joint venture plus an additional sum of $90,000 which, it was found, represented an estimate of the profit which it would have been entitled to receive upon the winding-up of the joint venture. Martland J. held that the sum of $90,000 was taxable given that the taxpayer, which made a business of entering into joint ventures with a view to profit, entered into the joint venture in question with the intention of recouping its investment plus a profit at the conclusion of the venture, and the $90,000 represented such a profit.

Donald Hart Ltd. v. MNR, 59 DTC 1134 (Ex Ct)

Damages received by the taxpayer pursuant to a court action brought by it against a company incorporated by a former executive of the taxpayer for that company's infringement of the taxpayer's trademark, were received "for the purpose of filling the hole in the appellant's profit which it could normally have expected to make, but which had been lost to it by reason of the tortious acts of the defendant" (p. 1137) and, accordingly, were taxable.

MNR v. Farb Investments Ltd., 59 DTC 1058 (Ex Ct)

The taxpayer previously had been leasing a property to a related individual ("Farb") who was operating a service station and a car-washing business on the property. It agreed to accept a surrender of the lease to Farb in consideration for the payment to it of $17,000 by an oil company ("Imperial Oil"), and leased the portion of the property used for the service station to Imperial Oil, which subleased its interest to Farb at the same rent. There was a new lease of the remaining portion of the property (used for car-washing) directly from the taxpayer to Farb.

Cameron J. noted that under the new leases, unlike the old lease, the taxpayer was obligated to pay taxes and insurance premiums and inferred that the $17,000 was received for the surrender by the taxpayer of the right to have such taxes and premiums paid by Farb, so that it was receiving in advance the amount of taxes and insurance premiums for the remaining (five-year) term of the lease. Accordingly, the $17,000 was required to be brought into income as rent.

See Also

additonal customer connection charges to cover loss were income receipts

Australian electricity distributors were entitled to require their customers to pay an amount equal to the estimated net economic burden to the distributors of hooking them up to electricity, i.e., where the the present value of the incremental cost exceeded the present value of the incremental revenue. Moshinsky J found that these “Customer Cash Contribution” amounts were ordinary income to the distributors as they were received “as an ordinary incident of their electricity distribution businesses” (para. 165).

The customer could instead choose to perform the work, in which case, on transferring the constructed assets to a distributor, the distributor would pay a rebate that did not represent the full cost of the work, so that again, the customer effectively bore the excess of the present value of the incremental cost over the present value of the incremental revenue (the “Customer Contribution”). In finding that a Customer Contribution was not ordinary income to the distributor, Moshinsky J stated: (para. 179):

[T]he Customer Contribution was not a payment or gain received by the Distributor; it was merely a component used in the calculation of the [rebate] amount to be paid [the other way] by the Distributor to the customer.

insurance benefits received by an ill dental surgeon to cover her practice expenses were taxable receipts

The taxpayer, a self-employed dental surgeon, received benefits totalling over $600,000 under three Great-West policies during a two-year period of illness. Two of the policies provided coverage for her monthly general professional expenses, and the third policy, styled as professional sickness insurance, provided monthly income replacement in the event of her illness. The taxpayer considered that there was no significant distinction between the third policy (replacing lost income) and the first two policies (covering business expenses). In affirming the Minister’s assessment, which treated the amounts paid out to the taxpayer under the first two policies as s. 9 income, Favreau J stated (at paras. 28-31, TaxIntepretations translation):

[T]he insurance benefits under dispute were paid for the purpose of reimbursing the appellant for part of the general expenses of her clinic during her period of illness and that were essential for the appellant’s clinic to continue being carried on … .

The source of the indemnification was a function of the business expenses incurred by the appellant for which there was a requirement to generate monthly statements for the general expenses incurred in the course of carrying on the clinic. Consequently, as the source of the insurance benefits was the business of the appellant, the insurance benefits paid to the appellant were required to be included in the computation of her business income.

… These benefits were not of a personal nature … .

The surrogatum principle … is applicable. By virtue of this principle, the tax treatment of sickness insurance benefits depends on what such benefits are intended to replace being, in this case, the general expenses of carrying on the dental clinic.

surrogatum principle references "why the compensatory amount was paid," and not confined to business receipts

In 1980, Nortel had established a health and welfare trust (the “HWT”) for its employees. Following its insolvency and filing under the CCAA (with the related CCAA proceedings being court-supervised), it made lump sum payments in 2011 to the four taxpayers, pursuant to a court-approved settlement agreement, in satisfaction of their entitlement to funding of life insurance premiums or of survivor death benefits. In characterizing such payments, and after noting that the surrogatum principle had been commonly expressed in the context of someone carrying on a business or having an adventure in the nature of trade, Sommerfeldt J quoted with approval the statement in Dumas, 2000 DTC 2603 regarding the surrogatum principle that:

The real question is to determine why the compensatory amount was paid.

and then stated (at para. 102):

In determining why the distributions were paid in 2011 by the HWT to the Appellants, I have concluded that the distributions were paid to Ms. Ellis and Ms. Kennedy as partial compensation for the termination of the Group Life Plan, and the distributions were paid to Mr. Scott and Ms. McCann as partial compensation for the termination of the monthly payment of their respective death benefits.

payments received in consideration for reducing lease payments were compensation for lost lease income, and s. 9 income

Leases by the taxpayer ("GMAC") to GM dealership customers stipulated a "residual value" at which the customer could purchase the vehicle at lease termination. General Motors of Canada Limited ("GMC") would make "residual value support payments" to GMAC in consideration for GMAC increasing the residual values (thereby reducing lease payments).

Initially, GMAC was entitled to retain all the support payments. In a subsequent period, "true up" payments were made on the lease terminations based on the actual loss (if any) experienced by GMAC relative to the (inflated) residual value, so that if that loss were less than the support payment (or nil, if the customer purchased the vehicle for the residual value), GMAC refunded the support payment to GMC to that extent (and, conversely, received a further payment from GMC if the loss were greater.) Graham J found that, for both periods, the support payments were includable under s. 9, and thus excluded from s. 12(1)(x) per s. 12(1)(x)(v). They should be so treated, rather than as a contribution toward the purchase of the vehicles, as their purpose was to compensate GMAC for its lost income. The situation was more in line with Ikea than Woodward.

Graham J stated (at para. 30):

Had the contract residual value been set where it should have been, the customers' monthly lease payments would have been higher. The residual value support payments had the simple effect of replacing that lost income.

A subdivision property of the taxpayer, a developer, was blockaded by Six Nations protesters. To diffuse the conflict, the Ontario government passed a by-law prohibiting any use of the property (rendering it valueless), and then agreed to pay the taxpayer $15,800,000 in exchange for relinquishing its rights to the property and under a court order against the protesters, and for a release.

C Miller J found that although the taxpayer relinquished its claim to the property, it had not "received $15,800,000 for the sale of worthless land" (para. 163). The property also "lost its character as inventory by being made legally useless for development" (para. 168) so that, even if the payment were for the property, it would be taxable only as a capital gain (para. 169). He concluded (at para. 203):

Henco's business was destroyed. By the time it struck an arrangement with Ontario, Henco had no value as a business ... : there could not be and there was not a source of income. The capital receipt was non-taxable.

The taxpayer and four others formed a joint venture to acquire, lease and sell a golf course. The taxpayer attempted to have a corporation of which he and two other of the participants were directors ("Disctronics") acquire the property. The other two joint venture participants (the "non-directors"), rather than agreeing, secretly acquired the gold course for their own account and sold it at a profit.

The taxpayer and the other two directors obtained a damages award against the non-directors for breach of their fiduciary duties to the three directors qua joint venture participants.

The taxpayer was assessed to include his share of the award in his income notwithstanding that Disctronics had received that amount and included it in its income. The High Court first held that the taxpayer had not received the award by reason of his position of director (as Disctronics never was admitted to the joint venture) and that no conflict had arisen between his personal interests and those of Disctronics. Accordingly, he had not become entitled to the amount as constructive trustee for Disctronics, and it was income to him.

payments styled as herd expense reimbursements in substance were capital receipts for destruction of business and were proceeds of the related agreements

A pharmaceutical corporation ("Weyth") had collection agreements with the taxpayers for their on-going collection of pregnant mare urine ("PMU") and its supply to Wyeth. In exchange for the release from its purchasing obligations, Weyth agreed to make substantial payments to the taxpayers, 80% of which was identified in the agreements as "payments for feed and herd health expenses." The taxpayers treated the payments as capital receipts for the disposition of capital assets (the collection agreements). The Minister reassessed them on the basis that they were business income.

Hogan J agreed with the taxpayers that the "payments for feed and herd health expenses" were capital receipts, given that:

the payments were not meaningfully tied to actual feed and herd health expenses - for example, the taxpayers were entitled to the payments even if they immediately sold their entire herds;

the motivation behind labeling the payments as "feed and herd health expenses" in the agreements appeared to relate to Weyth's difficulties with animal rights groups "and to counter a potential negative public backlash as a result of the destruction of the PMU herds" (para. 61); and

Weyth's cancellation of the contracts effectively drove the taxpayers out of the PMU business, and it was reasonable to conclude that the taxpayers were really being compensated for the destruction of their businesses.

Hogan J found that the parol evidence rule did not prevent him from considering the surrounding facts (set out above) in order to interpret the agreements. He cited (at para. 35) Ventas for the proposition that a commercial contract is to be interpreted, inter alia, "with regard to objective evidence of the factual matrix underlying the negotiation of the contract."

amount was received in respect of impaired capital asset (which then was transferred to payor) rather than for lost profits

On the early termination of a power purchase agreement between the taxpayer and the Alberta government, the taxpayer received $59.7 million from the Alberta government and the Alberta government became the beneficial owner of a power generation plant of the taxpayer, although the taxpayer continued as legal title owner and continued to operate the plant under an operating agreement with the Alberta government. As the parties were clearly of the understanding that the payment received by the taxpayer was for the transfer of its capital investment in the plant rather than being a payment for future profits surrendered, under the surrogatum principle, the payment was a capital receipt.

negotiated lump sum received for cancellation of non-compete was for diminutionin value of goodwill

A lump-sum payment received by the taxpayer in consideration for the cancellation of a non-compete covenant that had previously been given to it in connection with its acquisition of a business was a capital receipt given that the lump sum compensated it for a diminution in the market value of the goodwill that had been so acquired by it.

infringement damages were for lost profits (patents continued to exist)

A judge of the Federal Court determined that a competitor of the taxpayer had infringed the taxpayer's patents, but did not deal with the taxpayer's claim for damages or for an accounting of profits as this was to be dealt with in a separate hearing. Pursuant to subsequent minutes of settlement, the taxpayer received a lump sum of $6 million dollars from the competitor. In that finding this sum was an income receipt Woods J. noted that the claim of the taxpayer (as evidenced by its brief and memorandum filed in connection with the infringement litigation) was for lost profits rather than damage to its goodwill, that the action of the competitor did not in fact damage the taxpayer's patents in the sense of any diminution in the taxpayer's statutory rights under the Patent Act and that the fact that the parties came to a compromise and settled for an amount that bore no relationship to the profits lost by the taxpayer did not change the nature of the interest of the taxpayer that was settled. Woods J. also noted that if, instead, the competitor's use of the patented technology had been consensual, the arrangement would have been in the nature of a licence, the taxpayer would have been entitled to royalties, and that a lump sum in lieu of royalties generally is income.

A lump sum payment received by the taxpayers, following negotiation, with the sole tenant of their building, was an income receipt given that the payment compensated them for the loss of rental income, and there was no direct link between the payment and loss in value of the property. Respecting an argument that the lease was a capital item to the taxpayers, Miller J. noted that the taxpayers themselves did not have a leasehold interest in the property: they were the owners of the property.

BP Canada Energy Resources Co. v. The Queen, 2002 DTC 2110 (TCC)

The taxpayer, which was a Canadian natural gas producer, received a lump sum as compensation for the losses it was considered to have suffered as a result of the cancellation of long-term natural gas supply contracts it had entered into with one purchaser ("A&S"), with the result that it thereafter was to sell its natural gas under short-term gas supply contracts and under a continuation of modified versions of existing sales arrangements.

These lump sums were found to be proceeds of disposition of capital assets, namely, the long-term supply contract. The contracts formed a significant part of the structure of the taxpayer's business (representing over 13% of its sales) and their capital nature was fortified by the dedication under some of the contracts of the lands containing the gas reserves to be sold under such contracts. Furthermore, even if the payments received by it were measured by the present value of the profits it might be reasonably be expected to earn under such contracts, which was not the case (as it instead received an arbitrarily negotiated lump sum) this would not have deprived the payments of their quality of capital.

General damages which the taxpayer received in an action against a corporation of which he had been an officer and shareholder were exempt capital receipts given that his purpose in litigating was to protect and preserve his reputation as a resource company promoter. Damages recovered for failure of the corporation to indemnify against, and maintain insurance for, his litigation expenses also were capital receipts. After noting (at p. 724) the "difference between prejudgment interest on a debt or other liquidated amount wrongfully withheld, and on an award of damages assessed", Bowie T.C.J. found that prejudgment interest awarded to the taxpayer was taxable as interest under s. 12(1)(c) based on a finding in the civil action that the right to indemnity on which the interest was awarded arose on the date the taxpayer was sued.

R. Reusse Construction Co. Ltd. v. The Queen, 99 DTC 823 (TCC)

A lump sum received by the taxpayer (which owned an office tower) from its anchor tenant following the termination by the anchor tenant of the lease, was found to be an income receipt. Bonner TCJ. found that the effect of the payment was to compensate the taxpayer for the failure of the anchor tenant to discharge its obligation to pay rent under the lease.

C.I.R. v. McGuckian, [1997] BTC 343 (HL)

On 23 November 1979, the trustee who owned shares of a private company ("Ballinamore") assigned to a UK company the right to any dividend payable by Ballinamore in 1979 for consideration that was equal to 99% of the dividend that in fact was declared and paid by four days later. Before going on to consider the effect of an anti-avoidance provision, Lord Browne-Wilkinson found (at p. 349) that prima facie, this lump sum received for the assignment of a right to receive future dividends, would be capital.

Deeny & Ors v. Gooda Walker Ltd., [1995] BTC 470 (CA)

Damages received by Lloyd's names pursuant to their action against agents (who were member's agents) for their failure to exercise reasonable skill and care in conducting the business of underwriting on behalf of the names, were taxable as being received in respect of a trade carried on in the U.K.

IBM Canada Ltd. v. MNR, 93 DTC 1266 (TCC)

Lease inducement payments received by the taxpayer were taxable to it given that they were found not to have been intended as reimbursements for the cost of tangible personal property but, rather, as consideration for the taxpayer becoming subject to an ongoing obligation to pay (deductible) rent, and given that the negotiation of leases was an important part of the taxpayer's business. (It had 120 separate lease premises in Canada and an employee negotiated leases on a full-time basis.)

Trans Canada Glass Ltd. v. MNR, 93 DTC 1260 (TCC)

A cash incentive of $400,000 which a company engaged in the wholesale auto glass business successfully obtained as an inducement for entering into a lease of premises to be used for its head office was received free of tax given that it was the only such inducement ever received by the company, it was not in the business of buying, selling, trading or otherwise engaging in dealing in leases, and the payment was not tied to the amount of the monthly rent.

Young v. The Queen, 92 DTC 2387 (TCC)

The taxpayer had the right to receive $40,000 per annum for life (with certain survivor rights) from Col. Sanders Kentucky Fried Chicken Ltd. ("KFC") as a result of his previous agreement to terminate the arrangement under which he sold franchises in Canada for a fee of 1/2 of the resulting royalties. Later, when Pepsi Co. purchased KFC, it was agreed that the agreement to receive the annual amounts would be cancelled in consideration for the payment to him of two lump sums of $67,000 and $300,000. Although the cancellation agreement provided that he and his wife were to provide consulting services, it was found as a fact that he received the two lump sums in consideration for the cancellation of the existing contracts and relationships and that, accordingly, the sums were received by him on capital account as proceeds of disposition pursuant to s. 54(c)(ii)(B).

Nesbitt Thomson Inc. v. MNR, 91 DTC 1113 (TCC)

Lease inducement payments received by a holding company in connection with obtaining leases of office space which it, in turn, would provide to its operating subsidiaries, were found to have been received by it on income account based on a finding that it entered into the leases as part of its day-to-day business operations.

Yesac Creative Foods Inc. v. MNR, 91 DTC 413 (TCC)

The taxpayer, which regularly franchised restaurants, was found to have received on income account fixturing allowances which it received in connection with leasing space which it intended to sub-lease to franchisees. The taxpayer's "business consisted of the creation of pre-packaged restaurants with a view to selling them to franchisees ... [and] it was in the course of acquiring and preparing the restaurant premises which were intended to form part of the package to be sold that the inducement payments were received" (p. 416).

Donald Fisher (Ealing) Ltd. v. Spencer, [1989] BTC 112 (C.A.)

£14,000 which the taxpayer received as damages from an agent for his negligence in failing to give a timely notice under a rent adjustment procedure (with the result that the rent payable by the company under the remaining five years of its lease increased substantially) was compensation for an increase in expenditure which reduced the taxpayer's trading profits, and therefore was income. A submission that the damages had been received as compensation for a fundamental change in the nature of the lease, was rejected.

Poulter v. Gayjon Processes Ltd., [1985] BTC 112 (HC)

Wage subsidies paid by the Department of Employment to a shoe manufacturer were taxable.

Rolfe v. Nagel, [1980] TR 257 (HC)

An arguably gratuitous payment received by a diamond merchant broker was compensation for past unremunerated work or for loss of anticipated future profits, and therefore was taxable as a trading profit.

The taxpayer, which operated an oil storage installation that was supplied by tankers, suffered damage to a jetty through the negligent handling of a tanker by a third party. Partial compensation was paid by the tanker owners for the cost of repairing the jetty, as well as for profits lost by the taxpayer during the time that the jetty was unavailable for use. (The balance of the cost of repairs was paid by the taxpayer's insurer, under a policy which did not cover compensation for lost profits.) As the recovery of "the whole cost of repair, …[was] without doubt, a capital receipt" (per Wilmer LJ, at p. 509), the only issue was as to whether the compensation relating to lost profits was an income receipt.

In rejecting a submission by the taxpayer that this compensation was part and parcel of the compensation received for physical damage to a capital asset, Diplock LJ noted (at p. 516) that

The cause of action was based upon the loss sustained by the Respondent trader by the negligent navigation of the tanker, and the loss sustained because the jetty could not be used for 380 days would have been recoverable even if there had been no physical harm to the jetty, as, for example, if the tanker had sunk alongside the jetty, so preventing its use.

As the compensation in issue instead was received for lost profits, it was an income receipt. Diplock LJ stated (at p. 515):

Where, pursuant to a legal right, a trader receives from another person compensation for the trader's failure to receive a sum of money which, if it had been received, would have been credited to the amount of profits (if any) arising in any year from the trade carried on by him at the time when the compensation is so received, the compensation is to be treated for income tax purposes in the same way as that sum of money would have been treated if it had been received instead of the compensation. The rule is applicable whatever the source of the legal right of the trader to recover the compensation. It may arise from a primary obligation under a contract, such as a contract of insurance; from a secondary obligation arising out of non-performance of a contract, such as a right to damages, either liquidated, as under the demurrage clause in a charterparty, or unliquidated; from an obligation to pay damages for tort, as in the present case; from a statutory obligation; or in any other way in which legal obligations arise. But the source of a legal right is relevant, however, to the first problem involved in the application of the rule to the particular case, viz., to identify for what the compensation was paid. If the solution to the first problem is that the compensation was paid for the failure of the trader to receive a sum of money, the second problem involved is to decide whether, if that sum of money has been received by the trade, it would have been credited to the amount of profits (if any) arising in any year from the trade carried on by him at the date of receipt, i.e., would have been what I shall call for brevity an income receipt of that trade.

Cartwright and Sons Ltd. v. MNR, 61 DTC 499 (TAB)

followed in Bellingham v. The Queen, 96 DTC 6075 (FCA)

The taxpayer, which was a publisher of The Canadian Law List, settled its copyright infringement action against another company ("Carswell's") on the basis of Carswell's agreement to pay it the lump sum of $7,000 plus a royalty of 30% of Carswell's gross revenues from a competing directory for years specified in the agreement. Because the $7,000 was not paid in respect of any loss of income of the taxpayer (in fact, sales of its directory had increased following the infringement) and instead was received as exemplary or punitive damages, it was not subject to tax.

Keir & Cawder, Ltd. v. C.I.R. (1958), 38 TC 23 (C.S. (1st Div.))

The taxpayer, whose main activity was carrying on the trade of quarrymasters, sought to extend its business to civil engineering contracting by retaining a firm of consulting engineers to provide the services and reputation of one of their engineers. Insurance proceeds which the taxpayer received on the death of this individual represented compensation for loss of profits which it expected to make through utilizing his services and, accordingly, were taxable receipts.

William's Executors v. C.I.R. (1943), 26 TC 23 (C.A.), aff'd (HL)

In finding that a company received insurance proceeds for the accidental death of a valuable employee on revenue account, Lord Greene, M.R. stated (p. 37):

"If when an employer finds it desirable to expend money in getting rid of an onerous contract of service, the expense incurred is a revenue expense, it does seem to me to follow that the money received in respect of the loss of a beneficial contract of service falls into the same category; and, apart from the fact that no actual contract existed, that appears to me to be the present case."

The taxpayer carrying on business as a theatrical agent and producer of plays, acquired the scenery, properties and costumes to a play for £1,000, and also obtained a five-year licence to perform the play in the United Kingdom outside London in consideration for a royalty. Damages which the taxpayer received for infringement of the licence were an income receipt:

"The acquisition of the licence to produce plays is an ordinary incident of their business and ... the acquisition of each licence to produce a particular play does not constitute that licence a capital asset, but is merely the acquisition of their stock-in-trade" (pp. 512-513).

Smart v. Lincolnshire Sugar Co., Ltd. (1937), 20 TC 643 (HL)

The taxpayer, which already was entitled to receive annual subsidies in respect of every hundredweight of sugar or molasses manufactured during the 10-year period commencing 1 October 1924 from beets grown in Great Britain, received in 1931 further "advances" pursuant to the British Sugar Industry (Assistance) Act, 1931, which provided that such advances would be repayable by way of set-off against the annual subsidies in the event that the market price of sugar exceeded specified levels (which, in fact, did not occur). Lord Macmillan stated (p. 670) that "these payments were made to the Company in order that the money might be used in their business", and that the payments accordingly should be regarded as supplementary trade receipts.

Administrative Policy

any application of surrogatum principle to a penalty clause in a lease would depend inter alia on the lease and penalty terms

CRA stated that whether the surrogatum principle would apply to amounts received under a penalty clause contained in a commercial lease could not be made without a review of the penalty clause and the lease contract.

A corporation received a sum from its landlord in settlement of an action brought by the corporation for cancellation of a lease, which was not set to expire for a number of years and was a major business inconvenience. Would the settlement payment be included as business income or would it be considered part of the proceeds of disposition of capital property?

CRA referred to its statements in IT-365R2, paras. 8 (compensation for an income-producing asset v. loss of income) and 9 (indicating that a capital receipt relating to a particular asset is proceeds of disposition thereof, whereas a non-traceable capital receipt may be an eligible capital amount) and to the Canadian National Railway and Pe Ben decisions (respecting whether a cancelled contract is of critical importance) and (per its summary) noted that "generally, the treatment of a settlement payment is determined by reference to the surrogatum principle…according to [which]… a settlement payment is determined by reference to the amount it is intended to replace."

life insurance proceeds for rental property did not have the character of rents from an associated corp

Corporation A, a CCPC without employees which had been receiving rents from an associated corporation that were deemed to be active business income under s. 129(6), received insurance proceeds following a fire. After referencing the surrogatum principle, CRA stated:

Corporation A received payment from an insurance company as compensation for lost rents. Unless the conditions of subsection 129(6) are satisfied in this case, those rents are generated by a specified investment business and constitute income. As a result, the compensation paid by the insurance company to Corporation A constitutes income from property and does not constitute income from an active business.

As a break fee arguably is compensation for the transaction and opportunity costs that the bidder incurred on current account and wasted because its takeover bid failed, it arguably should be included in income under the surrogatum principle. In any event, as the underlying purpose of the takeover transaction was to maximize shareholder value through revenue growth and cost savings (per BJ Services), the break fee should be included in income as ancillary business income.

11 February 2005 Internal T.I. 2005-011284 -

Damages received from the Department of Fisheries and Oceans in respect of the denial of a supplementary fishing licence were received on income account. The taxpayers' business continued relatively unchanged as it had prior to the decision to deny the issuance of the supplementary licence, as the taxpayers had other licences and continued to fish. Moreover, the taxpayers were later issued a supplementary licence. The Directorate inferred that the payment was to replace lost income of the taxpayers.

12 June 2003 Internal T.I. 2003-001100 -

A contract termination payment received by the taxpayer was an income receipt given that termination of the contract (for the supply to it of particle board) would have caused its profits to decrease in the short term but would not have materially crippled its business.

termination of advisory agreemment with external MFT manager gave rise to capital receipt

A private corporation (XCo) derived almost all of its income as advisory and management fee income (as well as further fees on the sale or purchase of REIT property) pursuant to an Advisory Agreement between it and two of its executives and a REIT with which it dealt at arm's length. Although the Advisory Agreement had a definite term, it could be automatically renewed by XCo absent default. The parent of XCo (YCo) derived over half of its income from the provision of co-management and advisory services to the REIT on behalf of XCo.

In order to eliminate the fees, the REIT negotiated a Termination Agreeement with XCo, which provided that, following the amalgamation of XCo with YCo, there would be the payment of a stipulated sum, to be partly satisfied by the issuance of REIT units. Most of XCo's employees were transferred to the REIT. The sum received by Amalco was considered to be a capital receipt (and, therefore, as proceeds of disposition of the Advisory Agreement) given that the terminated contract had given rise to substantially all (in the case of XCo) or a substantial portion (in the case of YCo) of the revenues that, prior to termination, had been earned by the two advisors. Also of relevance was that the "Termination Agreement acknowledges that, under the terms of the Advisory Agreement, the REIT must pay an amount equal to the fair market value of this agreement, if it is terminated," and that the termination payment was not described as "a substitute for the future income that would have been earned under the Advisory Agreement."

An amount received by a client in settlement of her claim for income tax, interest and penalties resulting from poor professional advice concerning the disposition of a capital property would be a non-taxable capital receipt given that income tax, interest and penalties are not a deductible expense.

2 June 1994 T.I. 933572 (C.T.O. "Damages and Settlements")

"A payment in settlement of a damages claim to avoid or terminate litigation will generally be accorded similar treatment as damages for tax purposes even though there was no admission of any wrongdoing ... . [T]he receipt of damages/settlement will be ordinary income if it compensates for the loss of an amount that would have been income, be it from business, property or employment sources. If the facts in the case indicate that an amount was received as compensation for loss of, or damage to, a capital asset then the amount will be a capital receipt."

87 C.R. - Q.14

A lease inducement payment received by a firm in connection with its only business location generally will not be included in income.

87 C.R. - Q.15

Consumers Gas distinguished on the grounds that the expenses incurred by the company did not advance its profits and the payments received were in recovery of such costs and only for the purpose of advancing the interests of the payor.

85 C.R. - Q.21

The Saskatchewan livestock investment tax credit is treated as a reduction in feeding costs. The B.C. bond interest tax credit also is income.

IT-365R2 "Damages, settlements, and similar receipts" 8 May 1987

8. An amount received by a taxpayer in lieu of the performance of the terms of a business contract by the other party to that contract may, depending on the facts, be either an income or capital receipt. If the receipt relates to the loss of an income-producing asset, it will be considered to be a capital receipt; on the other hand, if it is compensation for the loss of income, it will constitute business income. Again, while it is a question of fact as to whether a receipt is an income or capital amount, the following factors are important in making this distinction:

(a) if the compensation is received for the failure to receive a sum of money that would have been an income item if it had been received, the compensation will likely be an income receipt,

(b) "where for example, the structure of the recipient's business is so fashioned as to absorb the shock as one of the normal incidents to be looked for and where it appears that the compensation received is no more than a surrogatum for the future profits surrendered, the compensation received is in use to be treated as a revenue receipt and not a capital receipt", and

(c) "when the rights and advantages surrendered on cancellation are such as to destroy or materially to cripple the whole structure of the recipient's profit-making apparatus, involving the serious dislocation of the normal commercial organization and resulting perhaps in the cutting down of the staff previously required, the recipient of the compensation may properly affirm that the compensation represents the price paid for the loss or sterilization of a capital asset and is therefore a capital and not a revenue receipt."

((b) and (c) above are quotations from the judgement in Commissioner of Inland Revenue v. Fleming and Co. (Machinery) Ltd., 33 TC 57 (House of Lords)).

1. A premium or other amount received by a landlord or tenant, as the case may be, as consideration for granting or extending a lease or sublease, permitting a sublease, or cancelling a lease or sublease is business income to the recipient if renting property forms part or all of a business being carried on.

4. Amounts a landlord receives from a tenant for cancelling a lease or sublease always constitute income to the landlord.

7. Subject to 1 above, a premium or other amount received by a tenant as consideration for

(a) assigning a lease,

(b) granting or extending a sublease, or

(c) in the case of an amount received from a landlord, permitting the cancellation of a lease

is a capital rather than an income receipt to the recipient. The tenant is considered to have relinquished a right or rights in respect of a leasehold interest, and thus such an amount represents proceeds of disposition of part or all of the leasehold interest.

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